Tuesday, January 29, 2013

Evaluating Dividend Growth Stocks – The Missing Ingredient

Over the past few years, I had developed and employed a stock selection strategy based on three criterion. These included screening for valuation, using a set of criteria such as minimum yields, dividend payout ratios and dividend growth. After I had a manageable list of stocks to focus on, I would do an analysis of company fundamentals for quality, while assessing the likelihood of future earnings growth.

The more time I spent running my screen and analyzing companies in detail, the more I realized that there was a partial disconnect between the two. I was more of an intuitive investor, who focused on dividend growth and yield, but could not really explain well why I had preference on one company over another in the pre-screened stock list.

The parameters for screening of dividend champions for example included:

The missing ingredient was evaluating companies on a case by case basis, based on the yield and growth characteristics they employed. For example, should I select a company yielding 2.50% that is growing distributions at 12%/year (BDX), or should I select a company yielding 4% that grows dividends at 6% (KMB)? If these growth rates are expected to continue for the foreseeable future (5 years from today), which company is a better candidate? Assuming that only one of the two can be purchased at a time, I usually bought the first in month one and the second in the next month. However, this still didn't really provide for an answer that would allow me to evaluate companies in a more standardized way, other than on a one-by-one basis.

This problem was also present when evaluating my dividend growth portfolio. Should I keep a stock yielding 4% that grows distributions at 1% per year or replace it with a company that yields 3% but grows distributions by 6% annually? This decision is particularly complicated given the uncertainty of projecting past dividend growth rates into the future, coupled with evaluating dividend payout ratios, valuation and prospects for earnings growth.

Some investors add the five or ten year average annual dividend growth to the current yield, and select the stock with the highest score. For example let’s assume that an investor had to choose between Yum! Brands (YUM) with a 5 year dividend growth rate of 17.80% and a yield of 2%, and McDonald’s (MCD) with a 13.90% growth and a 3.40% yield. The score for Yum! is 19.80 , while the score for McDonald’s is 17.30. The clear favorite in this scenario is Yum! Brands.

When looking at dividend growth rates however, the length of the dividend boosting streak is important if it exceeds ten years, but after that it should not be a differentiating factor. In other words, if all else is equal, a company that raised distributions for 35 years is not any better than a company that has raised them for 15 years. On the contrary, it could be argued that companies in the early days of their dividend achiever status might have more time to grow the dividend, in comparison to a mature dividend champion. Looking at Yum! Brands versus McDonald’s (MCD) however, then the latter earns more points, since it has been raising them for over 36 years, while the former only has a nine year record of dividend growth.

In addition, when we look at valuation, one might notice that McDonald’s is trading at 17.30 times earnings, whereas Yum! is valued at a P/E of 19.70. A big factor in Yum’s stronger dividend growth could have been the expansion in the dividend payout ratio, whereas it had been more stable at McDonald's.

On the other hand, future expected growth at Yum! is much higher than that for McDonald’s, as KFC franchises are opened at an increasing rate across the globe. Chinese market is in particular much more receptive to KFC than to McDonald’s restaurants, which is where a large portion of Yum!’s growth can be delivered over the next couple of decades.

The comparison becomes much easier when comparing a company such as Con Edison (ED) and an MLP such as ONEOK Partners (OKS). Con Edison has a five year dividend growth rate below 1% (0.90% to be exact), and it yields close to 4.30%. ONEOK Partners on the other hand yields over 4.70% and has a much high distribution growth rate of 5.40%/year. In addition, the growth prospects behind the partnership are much brighter than those for the New York State based utility, despite the much shorter streak of consecutive distribution increases for the MLP (38 years for ConEd versus 7 years for ONEOK Partners).

Overall, as part of my screening criteria going forward, I would use the sum of ten year annual dividend growth and current yield when comparing two or more separate investments. However, in my individual analyses of companies’ fundamentals, valuation and growth prospects, I would continue scrutinizing every aspect in order to come up with an investing decision. Unfortunately, one can only automate their investing to a certain extent, but then investors still need to evaluate qualitative characteristics based on their own investment experiences. Investing is part art and part science, which is why investing needs to be a mixture of hard data coupled with common sense and a dose of luck.

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